China’s muddled FX policy sows reform doubts

China has reportedly drafted a Tobin tax on foreign currency transactions – just the latest in a series of measures that appears to backpedal on financial reform. However, bulls say it’s a classic move by Beijing to limp towards reform without subjecting domestic markets to volatility.

China is reported to be introducing a Tobin tax on RMB forex transactions, to discourage speculation by increasing the cost of such trades.

The People’s Bank of China (PBoC) has made no public announcement, and there are therefore no specific details available, but Alicia Garcia-Herrero, chief economist for Asia Pacific at Natixis, says, if it is introduced, the PBoC would target short-term transactions – the obvious way to target FX speculation.

If China were to implement the measure, it would echo the country’s fairly muddled approach to currency reform and liberalization, potentially undermining other efforts China has made in recent months to increase liquidity.

In the plan, China indicates it will manage FX by negative lists, where foreign investors are assumed to receive the same treatment as Chinese investors unless they are explicitly added to a list for special treatment.

It will also loosen the restrictions on remittances of offshore investment and remove quotas for onshore and offshore investment.

Tiecheng Yang, Clifford Chance

Most FX market reforms implemented by the PBoC and the State Administration of Foreign Exchange (SAFE) were designed to attract more participants to the inter-bank FX market and further liberalize the exchange rate, says Tiecheng Yang, partner at Clifford Chance in Beijing.

He argues that as Chinese FX reserves decrease and markets anticipate longer-term weakening of the renminbi, China will continue to encourage foreign investment into China, issuing new rules that lower the market entry standards for foreign investors.

In January 2015, China opened up the inter-bank FX market to certain qualifying domestic non-banking financial institutions, including domestic securities companies, insurance companies and funds, without requiring prior approval by SAFE.

In September, it opened the market up further, first to overseas central banks and monetary authorities, international financial institutions and sovereign wealth funds, with 14 institutions registering to do so. Since December, it has been further opened up to foreign commercial banks, which are now also permitted to trade on inter-bank FX market.

The recent move to conduct daily open-market operations, rather than twice a week as it had previously, was also designed in part to increase liquidity in the market, says Yang, as well as stabilizing the money-market rate to be around the benchmark.

Meanwhile, on the exchange-rate liberalization side, trading hours for RMB were extended in January, with the market now remaining open until 11.30pm Beijing time, while the closing rate is set as the spot price of RMB/USD as quoted at 4.30pm. By overlapping with European trading hours, China hopes to set a more consistent RMB rate.

In August, the PBoC also reformed the daily central parity quoting regime for RMB/USD. Market makers now offer quotations to the China Foreign Exchange Trade System before the market opens, based on the closing rate on the inter-bank FX market the previous day; market supply and demand factors; and price movements in major currencies.

China also entered into currency swap agreements with 13 central banks in 2015, including Australia, South Africa, the UK and UAE.

However, the introduction of a Tobin tax would be an enormously regressive move, while Natixis’ Garcia-Herrero reckons it would be self-defeating.

“Investors – including speculators – will find ways to bypass the tax,” she says.

Detrimental

It could also prove detrimental to the broader economy by deterring hedging activities – a counter-productive move given the need for such activity as China opens its capital account.

“It seems again as if China’s short-term objectives – in this case deterring forex speculation – is harming more important long-term objectives such as fostering readiness to open the account,” says Garcia-Herrero.

The inconsistency of its approach to reform its FX regime reflects the delicate balancing act being attempted by Chinese policymakers. On the one hand they are pushing for reform and liberalization – in the currency markets and elsewhere in the economy. On the other, they are mindful of the need to maintain stability, on which its own political legitimacy is based.

When the two goals come into conflict, as they often do, it has consistently put its political needs – especially close to full employment and achieving its 6.5% growth target – above broader economic ones. It is generally unwilling to push through reforms that will pay dividends in the longer term, but ensure short-term volatility while the economy adjusts.

The IMF was clearly cognizant of this when it included RMB into the SDR basket. At 10.92%, its weighting is lower than the market expected, and is set to be increased as currency liberalization continues, giving it some leverage in motivating China to keep up its efforts.

Yang at Clifford Chance believes Chinese regulators are looking for a balance between in-flows and out-flows, adding: “When RMB is appreciating and there are too many foreign currency in-flows, SAFE will strengthen the regulations of foreign investment into China.

“However, when RMB was depreciating and there were too many foreign currency out-flows, we have seen reports indicating that SAFE is restricting outbound investments.”

China remains a global titan in manufacturing, and a weakening renminbi should be good news for its exporters because it makes Chinese goods cheaper for buyers in foreign currencies. However, recent polls by MNI Indicators – which conducts surveys of consumer and business sentiment, polling around 1,000 Chinese urban consumers and 300 Chinese companies listed in Shanghai and Shenzhen – show this has not been the case.

In fact, Chinese businesses are being pinched by a rising real, inflation adjusted rate, which has increased by around 15% against a basket of currencies.

This, perhaps, explains why Chinese authorities appear equally incoherent when it comes to monetary policy, where the PBoC has recently surprised observers with its mixed messages.

It initially indicated its willingness to support the government’s growth target using all the levers at its disposal, including a real rate cut and a higher inflation target of 3%. However, PBoC governor Zhou Xiaochuan then changed tack, sounding a more cautious tone and predicting a more prudent monetary policy as long as global market conditions allow it.

Alicia Garcia-Herrero, Natixis

Garcia-Herrero says: “The NPC [National People’s Congress] meeting reveals an economic plan that is more pro-growth than pro-reform.” In that sense, at least, China is being consistent.

However, as the economy rebalances towards consumption-led growth, with services increasing at the expense of low-end manufacturing, China should become more resilient in the face of currency fluctuations, says Philip Uglow at MNI Indicators. This should make it easier for China to liberalize the currency regime without increasing short-term risk to the economy.

In the meantime, Yang believes foreign investors are more concerned about the transparency of policymaking than the pace of reform. The agreement among G20 finance ministers and central bankers partially addressed this concern, ensuring that macroeconomic and structural policy actions will be carefully calibrated and clearly communicated, to reduce policy uncertainty and minimize any resulting market disruption.

Yang says: “Ultimately, the RMB exchange rate should be decided by China’s economic performance in a longer term. The concern of going too slowly or too quickly should be considered in a big picture.”

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